Chapter 4: The Market System

Equilibrium prices and quantities are established in individual product and resource marketAll product markets and resource markets are established through the market system (aka capitalism or private-enterprise system)

Characteristics of the Market System

Private PropertyFreedom of Enterprise & ChoiceSelf-InterestCompetitionMarkets & PricesReliance on Technology & Capital GoodsSpecializationDivision of LaborUse of MoneyActive, Limited Government

Private PropertyPrivate Property: Private individuals & firms, not government, own most of the property resources Enables individuals & businesses to obtain,

use, & dispose of property resources AS THEY SEE FIT.

Encourages investment, innovation, exchange, maintenance of property, & economic growth.

Includes intellection property through patents, copyrights, and trademarks.

Freedom of Enterprise & Choice

Freedom of Enterprise ensures entrepreneurs & private businesses are free to obtain & use economic resources to produce their choice of goods & services and to sell them in their chosen marketsFreedom of Choice enables owners to employ of dispose of their property & money as they see fit. Holds for workers & consumers.

Self-Interest

Each economic units does what is best for itselfEntrepreneur maximizes profits & minimizes lossesProperty owners aim for highest price on sale or rent of resourceWorkers find jobs w/ best combination of wages, hours, benefits, & working conditionsConsumers find best products they want at the lowest possible price

Competition

Requires independently acting sellers & buyers operating in a particular product or resource marketRequires freedom of sellers & buyers to enter or leave markets, on the basis of their economic self-interestNo buyer or seller can dictate the price of a productFreedom of entry & exit enables economy to adjust to changes in consumer tastes, technology, & resource availability

Markets & Prices

The coordinating mechanism of the market system is a system of markets & pricesThrough mechanism, society decides what the economy should produce, how production can be organized efficiently, and how the fruits of production are to be distributed among the various units that make up the economy

Reliance on Technology & Capital Goods

Extensive use of capital goodsEncourages use & rapid development of tools, machinery, factories, & facilities.

Specialization

Majority of consumers produce virtually none of the goods & services they consume while consuming little or none of what they produce.

Division of Labor

Human specializationSpecialization makes use of different abilitiesSpecialization fosters learning by doingSpecialization saves timeSpecialization increases total output derived from limited resources

Use of Money

Money performs many functions Most important function: Medium of ExchangeConvenient means of exchanging goods is required for specialization Barter: swapping goods for goods Coincidence of Wants

Must be generally acceptable to sellers in exchange for their goods & services.Paper money

The Market System at Work

Four Fundamental Questions1. What goods & services will be

produced?2. How will goods & services be

produced?3. Who will get the goods & services

produced?4. How will the system accommodate

change?

What Good & Services will be produced?

Since businesses seek profits and avoid losses, the g & s produced at a continuing profit will be produced; those with continuing losses will not be producedEconomic Profit = Total Revenue (TR) – Total Cost (TC)Total Revenue (TR) = Price (P) * Quantity Sold (Q)Total Cost (TC) = Cost of the Resource * Amount of the Resource

Profits & Expanding Industries

The presence of an economic profit is evidence that the industry is prosperous becomes an expanding industry: new firms are attracted by “above-normal” profits & enter, shifting from those less profitable.Entry of new firms is self-limiting. New firms enter the industry, market supply increases relative to market demand, lowering market price economic profit gradually diminishesMarket supply & demand conditions prevail when economic profit reaches zero (0) industry is at equilibrium size

Losses & Declining Industries

Firms are not attracted to unprofitable declining industries, with economic losses (costs > revenue)If losses persist, firms go out of business or shift industriesMarket supply of product in that industry falls relative to market demand, increasing market price economic losses gradually decreases, industry would stop shrinking

Consumer’s Dollar Votes

Consumers cast votes with the money (dollars) they spend.

Consumers register their wants through the demand side of the product market.

How will Goods & Services be Produced?

Competition forces out high-cost producers, continual profitability requires firms to produce output at minimum cost.Firms locate production facilities optimally, considering resource prices, & productivityFirms must employ most economically efficient technique of production Availability of Technology Prices of Related Resources

Economic Efficiency: Product output w/ least input of scare resources (measured in $)Changes in technology or resource prices may cause firms to shift from current technology.

Who will get the Goods & Services?

Any product will be distributed to consumers if they were willing and able to pay its existing market price.Amount of income depends on: Quantities of Property & Human Resources they

supply Prices of Property & Human Resources in the

market

Resource prices (wages, interest, rent, profit) determine the size of a household’s income ability to buy the economy’s output.

How will the System Accommodate Change?

Guiding Function of Prices Through changes in Prices, the market

system communicates consumer tastes

Role in Promoting ProgressTechnological Advance Market system provides strong incentive

(rapid spread) Creative Destruction: The creation of new

products & production methods that are better than existing ones (DVDs)

Competition & “The Invisible Hand” Principle

In 1776, Adam Smith wrote The Wealth of Nations: Union between private & social interests Firms & resource suppliers act in their own self-

interest simultaneously to promote public/social interest, as if guided by an “invisible hand.”

Competition controls and guides self-interest to further society’s interests.An invisible hand ensures that when firms maximize profits, they also maximize society’s output and income

Merits of Market System

Efficiency Promotes efficient use of resources, guiding

towards production of most desired goods & services

Incentives Encourages skill acquisition, hard work, &

motivation economic rewards

Freedom Emphasizes personal freedom Coordinates activity w/out coersion

Chapter 4 Study Questions

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